Letter to Representative F. James Sensenbrenner, Jr. on balanced budget

September 21, 2004

Rep. F. James Sensenbrenner, Jr. Chairman, Committee on the Judiciary House of Representatives 108th Congress

Dear Mr. Chairman,

As it completes work on a budget that could be in deficit to the tune of $300 billion, your committee and the U.S. House of Representatives will consider a joint resolution in support of a balanced budget amendment to the Constitution of the United States. The proposed text of the amendment invites a multitude of questions as to implementation and enforcement, and the timing of the proposal’s reincarnation evokes wonder. But the crux of the matter is whether a routinely balanced budget makes good economic sense. It does not, either from the standpoint of long-term fiscal discipline or short-run anti-recession policy.

Over the past three years, the U.S. Congress has repeatedly made decisions that worsen the long term budget outlook. The proposed amendment seeks to require a balanced budget, beginning in Fiscal Year 2010. In January 2001, the Congressional Budget Office projected a budget baseline for FY 2010 that boasted a $796 billion surplus. Several weeks ago, the Congressional Budget Office issued a new baseline for FY2010 that is $298 billion in deficit.

If the tax cuts are extended through 2010, including a low-cost reduction in the Alternative Minimum Tax, CBO estimates an addition to the deficit of $193 billion, for a total of $491 billion, or more than three percent of GDP. Voting now for some future Congress to somehow balance the budget is an unseemly distraction from current tax legislation that would make such a task inordinately difficult, as well as damage the nation’s economy.

In January of 1997, more than a thousand economists – including 11 Nobel Prize winners – signed a statement condemning a balanced budget amendment to the Constitution. The rationale in their statement – appended below – remains valid today. Two central economic arguments against an amendment pertain to long- and short-run policy, respectively.

Long-term fiscal discipline

In popular debate, the alternative to budget balance is often depicted as wretched excess – undisciplined borrowing, leading to out-of-control tax cuts and spending increasing, compounded by spiraling interest costs.

But such persistent exponents of fiscal discipline as the Congressional Budget Office and the Government Accountability Office have asserted that moderate deficits can be sustained indefinitely:

“Other approaches could also create sustainable budgetary conditions. For instance, a budget that was permanently balanced would freeze the level of federal debt. Thus, as the economy grew, debt would gradually fall as a share of GDP. However, sustainable policies do not require balanced budgets. As long as deficits do not grow relative to the economy, the government could in principle keep the budget in deficit forever. Under the assumptions of CBO’s long-term simulations, if the government stabilized the NIPA deficit at its current share of GDP (about 1.7 percent), the debt would remain close to its current share of GDP indefinitely.” (Congressional Budget Office, March 1997)

“Q. What are the key issues in evaluating the overall level of debt for the future? A. In assessing debt levels, it is important to focus on the right indicator of the burden of the debt. As we have noted earlier, comparing the debt to GDP provides a better indicator of the debt burden than the debt’s nominal dollar value, because it captures the capacity of the economy to sustain the debt.” (U.S. General Accounting Office, November 1996)

Moderate deficit levels are tolerable for an indefinite period of time. The Federal government’s solvency is at risk when deficits are so large that debt persistently rises more rapidly than GDP. Unfortunately, that is the current outlook for the Federal budget if the tax cuts of the past three years are made permanent. Adherence to PAYGO rules that have been ignored in the past three budgets would have blocked tax cuts with such deleterious long-run implications.

Another concern gathering some force is that the retirement of the Baby Boom will put unprecedented strain on the budget, due to automatic increases in entitlement spending. A recent report from the Congressional Budget Office (2003) makes clear that the overwhelming bulk of the anticipated problem in this vein is due to health care spending in Medicare and Medicaid.

It is naïve to think that “we can’t afford” health care spending under Medicaid and Medicare, but we can afford it if program benefits are cut and privatized in some fashioned. A recent report from the Kaiser Family Foundation (2004) reports that health insurance premiums in the private sector are rising at double-digit annual rates. In light of the fact that median family incomes since 1970 grew at roughly five percent a year (and less in more recent years), private sector health insurance is no more sustainable in the long run. Benefits no longer financed by Medicare or Medicaid would be financed by out-of-pocket spending or private sector health insurance premiums. Alternatively, people would “pay” by foregoing medical care. There is a heavy burden of health care policy reform that a balanced budget amendment cannot solve and could make more difficult.

If deficits are tolerable, would we still profit from eliminating them altogether? The principal argument made by some economists is that Federal borrowing precludes private sector investment and reduces economic growth. The explanation is that when the Federal government increases its demand for credit, the market rates of interest increase, making business borrowing more expensive.

In and of itself the argument makes sense, but it opens to question the magnitude of the impact on investment, the net effect on the performance of the U.S. economy. Business investment is not motivated solely by the cost of borrowing. It also depends on expected sales. Even though the recession officially ended in 2001 and was followed by persistently low interest rates, private investment did not recover until the third quarter of 2003.

The Federal deficit outlook has undergone a stark turnaround since January of 2001, when ten-year budget surpluses totaling $5.6 trillion were projected. One might have expected a violent rise in interest rates as a result, since projections are now for trillions in deficits. Thus far, interest rates have remained low.

What might limit the impact of deficits on interest rates? Because capital markets have become increasingly global, the pool of potential lenders to the U.S. Government and private citizens has grown. A significant portion of the budget deficit is financed by foreign lenders.

Empirical research on the deficit-interest rate link is mixed. Two leading proponents of the link, Bill Gale and Peter Orszag (2004), caution that an effect of current deficits on observed interest rates is unlikely. Their concern centers on expected future deficits. A question is the extent to which current business decisions are affected by changes in long-term deficit trends. It is certain that explosive growth in debt would be a concern. If the growth in debt were sustainable, however, the import of smaller changes is a different matter.

What is
not in question is that deficit reduction implies some sacrifice in public benefits and services, including public investment, itself an essential component of economic growth. As noted above, under current trends and with extension of the tax cuts, the deficit in 2010 would be $491 billion. 2010 is when budget balance is required under the proposed amendment. The Congressional Budget Office (2004) projects baseline non-defense discretionary spending in 2010 at $497 billion (after excluding outlays for homeland security). So if the politically daunting baseline levels of entitlement spending, defense, and homeland security are held harmless, balancing the budget in 2010 implies the elimination of nearly all non-defense discretionary spending. From this standpoint, a balanced budget requirement implies a completely dysfunctional, not to say whimsical budget policy. Surely the costs of achieving a balanced budget in 2010 would exceed the benefits of such a policy.

Short-Run Anti-Recession Fiscal Policy

It is generally accepted that deficits are tolerable in times of recession and sluggish recoveries. There is a strong consensus among economists that efforts by President Herbert Hoover to balance the budget from 1929 to 1932 contributed to the depth of the Great Depression. Even though the recent recession of 2001 was relatively mild, the recovery has been weak. Employment continued to fall until August of 2003. Balanced budgets in 2002 or 2003 could have choked the turnaround in the economy, such as it was. Even now, an unemployment rate that has risen by 1-1/2 points in four years masks a significant loss of job opportunities for millions of uncounted workers who have left the labor force.

In the latter half of the 1990s, unemployment fell to much lower levels than presently – under four percent, the Federal government retired $559 billion in debt, and spending grew more slowly than it has since 2000. Well-designed budget rules and responsible legislation, not a balanced budget amendment, made that result possible.

What has changed since 2000, as far as economic policy-making is concerned? Only the leadership of the Executive branch of government and the irresponsible choices of the Congressional majority. Evidently, the authors of the balanced budget amendment are the villains in their own tale.

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